Preston Byrne

The Problem with Calling Bitcoin a “Ponzi Scheme”

As talk of Tulips and Ponzi schemes increases commensurately with Bitcoin’s price, I thought I was being clever when I sent out a tweet reading: “Rhymes with Fonzie.”

Fonzie is fun. And that was a fun tweet, but on reflection not an especially clever one. Very fortunately, it elicited this brilliant reply:

You know something, @DontPanicBurns? You’re absolutely, 100% right. we need a new term to describe what’s going on here.

I propose we use your term, the “Nakamoto Scheme.”

The problem with calling Bitcoin a Ponzi scheme

When we talk about Bitcoin, or Ethereum or any other digital coin, for that matter, neither “ponzi” nor “pyramid” are perfectly accurate descriptions for how these systems actually work.

Ponzi schemes, as traditionally run, usually are administered by a central operator (Charles Ponzi, Allen Stanford, Bernie Madoff, Sergei Mavrodi) who is responsible for bringing in new funds and disbursing withdrawals from the scheme in an orderly fashion. These schemes fall apart when demands exceed deposits and the scheme promoter is unable to satisfy investor requests, causing a loss in confidence or a run which first ruins the scheme’s liquidity, which in turn ruins the scheme as a whole (or rather, brings the scheme to its inevitable end, since Ponzi schemes are doomed to die from the moment of their inception – none can expand forever).

Pyramid schemes, by contrast, are more decentralized in character. Each victim of the scheme, to recoup their funds, is required to become a principal in the scheme and recruit further victims, who then pay the principal and earlier principals above him. Not all multi-level schemes that are pyramidal in structure are illegitimate; see, e.g., Avon, which has a genuine product at its core  and employs a legally-sound “direct selling” structure. Other types of pyramid schemes, where licenses to recruit new members are the sole product, are illegal, whether they be small-time pyramids that target housewives such as “secret sister gift exchanges” or flagrant pyramids like the Dare to be Great scheme in the 1970s, where the product was the right to sell the product, and little more.

For this reason, it is perhaps time for the literature to describe new class of investment scam – the truly ugly nature of which will only be revealed after the coin bubble bursts – a class of fraud which uses technology, rather than a scheme operator, to mediate the interactions between an investment scam’s beneficiaries and its dupes.

Describing the “Nakamoto Scheme”

The Nakamoto Scheme is an automated hybrid of a Ponzi scheme and a pyramid scheme which has, from the perspective of operating a criminal enterprise, the strengths of both and (currently) the weaknesses of neither.

The Nakamoto Scheme draws strength from the same things which make pyramids and Ponzis so compelling, in that it promises insane investment returns, can be accessed by the man on the street with almost no effort at all, and recruits individual participants as new, self-interested evangelists of the scheme.

It has no current weakness in that the regulators, blinded by lobbying from the Valley, have seen these schemes as futuristic and cutting-edge rather than what they really are: victim factories, which in the next crash will produce hundreds of thousands of howling investors with little formal legal recourse due to four years of inaction on the regulators’ part.

1. No operator, many operators

Nakamoto Schemes have no central operator. This ensures that no single member or entity can be held liable (as with a Ponzi or pyramid) and obscures the identity of participants from law enforcement.

This also, like a pyramid scheme, has the insidious quality of turning every victim of the scheme into a new principal as they talk up their books for the purpose of recruiting new investors to subsidize their exits.

These incentives are often combined with the 21st-century software disciplines of community management and technology evangelism in a a potent mix of marketing and corporate/moneyed interests that is impossible for punters on the street to ignore (Coinbase is currently pulling in 100,000 new users per day).

2. No hypothecation

Most interestingly, Nakamoto Schemes also dispense with the need for a cashflow that gives rise to legal liability. Sometimes Ponzi, but more often pyramid, schemes involve specific funds being given to a specific person with a specific expectation of a specific return; they are, to borrow a term from tax law, hypothecated, legalese for “spoken for,” and legal liability arises because it is simple for regulators to identify the flows and attribute to them a legally improper purpose. It is for this reason that many jurisdictions penalize not merely running or starting  a pyramid scheme but the mere act of participating in one (more on that below).

Curing the damage from a Ponzi scheme, on the other hand, is an exercise in tracing transactions that passed through the scheme managers, determining whether those transactions were bona fide or fraudulent, clawing back what they can from recipients of fraudulent transactions, and then deciding the appropriate method for restitution such as, e.g., distributing proceeds ratably or allowing the losses to “rest where they fell.” Profiting from a Ponzi turns one into a victim and perhaps a recipient of ill-gotten funds, but not necessarily a principal, as participation a pyramid scheme might.

Cryptocurrency cashflows avoid these problems in that they are unhypothecated. By adding a layer of abstraction in the form of cryptocurrency exchanges, they eliminate what would otherwise be blatantly illegal cashflows and contracts, and disguise what is in all material respects an identical investment program as a generic pool of aggregate demand meeting a generic pool of aggregate supply.

So far, this structure and a lack of adequate legal tooling (or prosecutorial will) to penalize it has allowed promoters of thousands of cryptocoin schemes, some more legitimate than others, to avoid being labelled either as principals (as they might be with pyramid schemes) or as recipients of ill-gotten funds with foreknowledge (as with Ponzis).

As a result, we have seen a seemingly endless proliferation of technically weak technology boosters rolling out spurious sales arguments such as “it’s the value of the network!,” or hyping the living daylights out of a new coin by lending it the name of  prominent Valley venture funds, to justify increasing the quantity demanded of the coin and therefore their own profits, even where the schemes in question are quite undeniably destined to fail.

This is totally irrational from a software development perspective, as cryptocurrency networks’ performance is vastly inferior to what already exists:

For contrast, Bitcoin gets about 3 transactions per second, with one “currency,” and the network is currently clogged.

Which rather lends itself to the suggestion that Bitcoins are primarily purchased for resale and speculation rather than for any genuine utility.

Though inferior in raw performance than a system like Visa, the fact that these networks employ “markets” rather than specific cashflows for liquidity makes them superior for a criminal enterprise in that it’s a lot harder to prove a random, pseudonymous exchange transaction is part of a criminal enterprise than it would be to show that, say, a briefcase full of 500-euro bills, or an e-mail solicitation with instructions to wire funds to a bank account in the Cayman Islands, is being used as part of a criminal enterprise.

3. Automation

The Old Testament tells us: “there is no honour among thieves.”  Nakamoto saith: “there need be no honour among thieves.”

Blockchain consensus allows thieves to coordinate their actions and run this system without needing to trust a central operator.

This means that the activity is able to continue without any individual liability being incurred by the participants. But in order to do this, the system imposes a real and very significant cost on cheating:

Considering the alternative (using mainstream finance, being surveilled, and landing in jail), I can see how some folks might see this as a price worth paying in order to access the billions of dollars currently sloshing around in the Bitcoin markets. I include within the definition of “Some Folks” not just users of these cryptocurrencies but also some creators, mainly the ICO promoters who disclaim responsibility for their creations once they loose them into the wild (having first allocated themselves a hefty pre-allocation of their own coins, known as a  “pre-mine,” to compensate themselves for their unbridled genius).

4. Legislative responses

What are we to do if this bubble starts spinning wildly out of control and governments need to get mediaeval on digital coins? And by this I’m not talking about ho-hum enforcement of KYC/AML and securities laws like we can expect to see today. I mean, like, strict-liability, no-holds-barred, raiding-crypto-Meetups, Marsellus Wallace levels of mediaeval.

Easy peasy.

Subject to the usual caveat that I’m an English solicitor and not a U.S. attorney, the English rules are a bit blah and bound up in either common-law fraud or unfair trade practices regulations, so they’re not very Ponzi-specific and, accordingly, not well suited to this blog post.

Fortunately, I found a super handy law in the form of New York’s General Business Statutes on Chain Distributor Schemes which makes a much better hypothetical:

1. It shall be illegal and prohibited for any person, partnership, corporation, trust or association, or any agent or employee thereof, to promote, offer or grant participation in a chain distributor scheme.

Cool. So nobody can participate in a “chain distributor scheme” in New York, it seems.

What is such a scheme?

2. As used herein a “chain distributor scheme” is a sales device whereby a person, upon condition that he make an investment, is granted a license or right to solicit or recruit for profit or economic gain one or more additional persons who are also granted such license or right upon condition of making an investment and may further perpetuate the chain of persons who are granted such license or right upon such condition.  A limitation as to the number of persons who may participate, or the presence of additional conditions affecting eligibility for such license or right to recruit or solicit or the receipt of profits therefrom, does not change the identity of the scheme as a chain distributor scheme.  As used herein, “investment” means any acquisition, for a consideration other than personal services, of property, tangible or intangible, and includes without limitation, franchises, business opportunities and services, and any other means, medium, form or channel for the transferring of funds, whether or not related to the production or distribution of goods or services.  It does not include sales demonstration equipment and materials furnished at cost for use in making sales and not for resale.

Any chance of a securities law angle?

3. A chain distributor scheme shall constitute a security within the meaning of this article and shall be subject to all of the provisions of this article.

Why might policymakers want to include a financial-regulatory angle? Because, at the end of the day, the market is treating this stuff like investments, and the laws on the books are designed to protect — you guessed it — investors. The law should therefore regulate digital coins like it regulates other types of investments.

Exhibit A:

So let’s digital-currency-ify this New York law, and drive Peter van Valkenburgh and the Coin Center folks completely insane in the process, by proposing to amend NY GBS § 359-fff(2) to read as follows:
2. As used herein a “chain distributor scheme” is (A) a scheme or sales device whereby a person, upon condition that he make an investment, is granted a license or right to solicit or recruit for profit or economic gain one or more additional persons who are also granted such license or right upon condition of making an investment and may further perpetuate the chain of persons who are granted such license or right upon such condition; or (B) a scheme or sales device whereby a person purchases a digital token with the expectation of appreciation in value based primarily on the recruitment of additional persons in the digital token scheme where the token is intended to be and is in fact primarily redeemable for money or money’s worth, rather than being a contractual right to a specific and identifiable good, service, security, license, or other tangible or intangible property other than money or money’s worth, except for the type of license or right to solicit set out at (A) above.  A limitation as to the number of persons… etc. 

Great idea?

Terrible idea?